Managers' views

Managing corporate controversies: the role of environmental, social and governance (ESG) ratings

We explain why ESG integration is not just about managing downside controversy risks but the insight it can bring to future growth.

14/09/2017

Alexander Monk

Sustainable Investment Analyst

High profile corporate controversies are regularly used to highlight the value of ESG analysis.

Volkswagen’s emissions scandal, Enron’s fraud and BP’s Deepwater Horizon oil spill each appear to provide tantalising examples of the significant losses that could potentially have been avoided through a better understanding of company practices.

Our analysis suggests investors hoping conventional ESG ratings will help to identify these problems before they break are likely to be disappointed (Figure.1):

ESG ratings have shown no clear predictive value

Better-rated companies appear slightly more likely to experience controversies than worse-rated companies. This suggests that tick-box indicators of company sustainability are ineffective measures of controversy risk.

ESG ratings have reacted to controversies

On average, ratings have fallen by a full rating notch in the few months after a controversy becomes public. Most ratings include corporate controversies in their calculations, and while this mitigates the reputational risk of having high ratings for challenged companies, it disguises their limited predictive power.

Past controversies are a bad guide to future controversies

We find no meaningful relationship between the number of controversies a company has faced and the likelihood it suffers a future controversy. Ratings that rely heavily on past controversies therefore risk undermining their own effectiveness.

The value of ESG integration

This does not mean third party ESG ratings have no value. Instead it underlines the importance of understanding what they are and how they should be used. To us, effective ESG integration means examining a company’s ESG performance and incorporating that analysis into investment decisions.

Moreover, effective ESG integration is not just about preventing large downside controversy risks. Rather, the key value of examining business model sustainability lies with the insight it can bring to future growth.

 

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